Securities lending agreements in the US were found to be robust, despite the crisis. Experts discuss market challenges and developments. (part 1)
Dennis Fernez (NY State Insurance Department), Josh Galper (Finadium), Anne Sylvester (JP Morgan WSS)
Freeman Wood (Mercer Sentinel), Laurie Zeppieri (Citi)
Funds Europe: How was the US securities lending market impacted by the crisis? Were assets lost in the Lehman Brothers’ collapse and if so, have measures been introduced to prevent that from happening again?
Laurie Zeppieri, Citi: There was a time when the music stopped and everything froze, which prevented lenders and lending agents from accessing securities that were out on loan. Notwithstanding the fact that the insolvent borrower was incapable of returning securities, we found the unwind process to operate efficiently and in a manner that served to protect the interest of the lender because of the way the agreements are structured. The contracts clearly defined the rights and obligations of the parties which allowed the lending agent to take immediate action and seize and liquidate the collateral and execute what we call ‘buy-ins’, that is to buy securities equivalent to those the defaulted counterpart was unable to return. At Citi, all lenders with securities outstanding to Lehman at the time of the insolvency received back either securities or cash equivalent to the value to their securities.
Josh Galper, Finadium: I agree with Laurie. We didn’t see any problem with lenders losing their securities; it just wasn’t an issue. The longer-term implications we’ve seen are around losses from Lehman bonds, from SIVs and other asset-backed products that lost value. Some of these are regaining their value now, so people who held on to their securities are seeing a return in market value. Also, some agent lenders were able to engage in the process Laurie described days before the default of the Lehman unit with which they made the trade. This was because of cross default agreements within the Lehman organisation. So, if one division were to have defaulted, it could trigger a buy-in throughout other divisions.
Freeman Wood, Mercer Sentinel: I agree with Josh. We didn’t see any material impact on clients in terms of them getting their securities back. What did get frozen was some of the cash collateral investments invested in Lehman and other illiquid bonds, for example, through a fund. This is what led to losses.
Anne Sylvester, JP Morgan Worldwide Securities Services: Our experience was very similar to what Laurie described. In a sense, the Lehman crisis proved that our model was efficient in unwinding when a borrower defaults. We were very successful in getting securities back and only a very small percentage was returned in cash.
Zeppieri: I would agree as well that at Citi there was a limited number of lenders that received cash in lieu of securities.
Sylvester: It gave lending clients the comfort of knowing that the mechanism does work in difficult situations and market disruptions.
Dennis Fernez, NY State Insurance Department: From the regulator’s point of view, we didn’t really see many problems. The only company that we were aware that was dealing with the Lehman problem was AIG, but everthing worked out. But the other companies that dealt with Lehman did not report any issues to us and we didn’t see any material market losses or anything of
Zeppieri: It suggests that the agreements proved to be thoughtful and to take into consideration this type of an event. To your question about whether or not there was a need to change the agreements in the aftermath of Lehman, I think the experience in the US was very different to that in the UK. In the UK, a number of changes were made to the industry standard agreements to address limitations that came to light in the aftermath of Lehman. In the US however, the agreements were found to be very robust. They take into consideration all the different facets needed to protect the parties in the event of insolvency and the lender had full rights to the collateral. As a result, we have not seen changes being proposed or discussed that would be necessary to protect the lenders in the US.
Wood: Yes, in fact the cross-default provisions Josh mentioned earlier helped lenders take action much quicker than they would have been able.
Sylvester: We have experienced an increased scrutiny over the indemnification language used. However, this is around understanding it better and not about changing it. For new lenders in the market, there is certainly a focus on really understanding how it works. This increased focus is not about major flaws in any of the contracts, it’s more about education. If you weren’t engaged in a lending program when Lehman defaulted, you would want to understand the mechanics of how that process works.
Fernez: I don’t think our industry has a full understanding of exactly where the Dodd Frank Act is going to end up and how it’s going to affect players in the market. We are reviewing it and trying to understand where we might end up, but there’s little else we can do at the moment.
Zeppieri: The one area of Dodd-Frank that the industry is carefully watching is the proposed one-day stay on an insolvency of a significant market participant. This might have implications as to how we operate in the future with regard to insolvency.
Sylvester: The other area we’re paying attention to is the scrutiny around alternative investment fund managers: what their requirements will be and how it’s going to restrict their activity in the marketplace, which ultimately will have an impact on demand. This is more of an indirect effect on the overall health of the industry.
Galper: I would add that both Dodd-Frank and Basel III, when it’s finally released, will have substantial impacts on the collateral management markets which will, in turn, have knock on effects on securities lending.
Funds Europe: Is the end client becoming more involved in the process of drawing up agreements?
Zeppieri: At Citi, the end client has traditionally been involved and as an aftermath of Lehman and the financial crisis has become even more involved. Lenders want to understand the implications of all provisions of the lending agreement, not just the ones related to insolvency. As Anne pointed out, indemnities were, and continue to be, an area of particular focus. Lenders endeavour to fully understand their rights, obligations and protections.
Galper: Before the crisis we saw a number of securities lending agreements between beneficial owners and agents. Some were robust and some were not very robust. Now beneficial owners are more aware of the process and are much more involved, particularly around the guidelines and collateral management, where some experienced real losses.
Wood: I completely agree, that’s what most of our clients have been focused on this year. They evaluated their agreements and securities lending programmes across the board. There was a wakeup call that there was a lot more risk there than they thought. Risk management is now more focused on the cash collateral reinvestment risk. This is the area in which people need to understand their rights and what involvement they should have in the decision process. Most of our clients are spending time understanding the level of risk that they have in the programmes and what they can do about it going forward.
Funds Europe: Is it more difficult to get new beneficial owners to lend securities? Or are they willing to lend as long as their fears are allayed in terms of collateral?
Sylvester: We’ve seen new entrants to the market for a variety of reasons. There were lenders who had suspended their programmes and have now re-entered the market. We’ve seen a very healthy trend of increased scrutiny and oversight from these lenders as a result of the crisis.
The new entrants are looking at it from a variety of different perspectives. For example, it [securities lending] might represent additional revenue potential for their overall fund portfolios. The new lenders have read the press, seen what others experienced and as a result, they are entering the market as very educated consumers. There is a broader understanding of all the intricacies of the programmes.
Wood: That education is around the risk/return. Before it was more of a revenue decision, but people are now realising that it is a risk/return decision both in terms of a lending risk as well as cash reinvestment risk.
They are more keenly aware of the returns needed to justify the risk they’re taking, both the known and unknown risks.
Zeppieri: With respect to market activity in general, right after the Lehman crisis there was a temporary hiatus. There were suspensions and other actions by lenders throughout the industry as well as a decline of new entrants into the securities finance market. I’m happy to say that from my vantage point, I am seeing strong interest from lenders across the globe to both expand their programme as well as enter the market for the first time. There is however, a more thoughtful approach when entering the market.
Galper: Both in Europe and the US securities lending wound up being somewhat vilified in the press, when in fact it has been, and continues to be, a very healthy functioning process. Certain aspects of collateral certainly didn’t work out in the way that lenders had hoped but by no means was securities lending evil.
Fernez: From a regulatory perspective I’m glad to hear that the parties involved are getting together and talking about it a lot more. Securities lending, just like other financing arrangements, was under the radar of a regulator because it usually was a relatively risk-free, short-term transaction.
When we saw the programmes our eyes were opened a little bit to the extent of how certain things were spread out and how they were really earning their basis points.
But certainly by no means do we believe that securities lending was evil. We think securities lending does have a place, certainly in the insurance industry.
A lot of companies in the insurance sector scaled back their programmes since 2008. There are still relatively sizeable programmes out there that are running pretty well.
The New York State Insurance Department issued a circular letter as guidance that has a limit of 5% of admitted assets for security lending activities. It may have alarmed some people but it was guidance issued to encourage dialogue, not create a hard 5% limit. What it does is bring securities lending into the same regulatory view as that dollar rolls or repo agreements. What we wanted to achieve by issuing the circular was a dialogue with companies that were going to exceed 5%. Up to 5% they could go about their business without speaking to the regulator but once that level is exceeded we want them to come in and talk us through the controls they have in place.
Fortunately for us, we know the major programmes out there. We reviewed them after the AIG situation and we found the controls to be very strong and robust.
Wood: Clients are starting to understand that this is an investment decision like any other, and that getting a grip on all aspects of it, including the risks and the returns, is a critical part of the decision process. They’re not just asking whether they can earn extra revenue from securities lending but they’re now asking what the inherent risks are. It’s become a decision they need to make proactively and review regularly as part of their processes.
Fernez: In our circular we explained that we would be taking a harder look at the reinvestment side of things, because that’s really what tripped everything up. No one who does securities lending expects everybody to ask for their cash back all at once. People have lending programmes on what they call a roll; they keep sufficient liquidity to be prepared for surprises. But you can’t have enough liquidity for the ultimate surprise of everybody asking for their money at the same time.
Galper: I think it’s very healthy that groups like Dennis’s are taking proactive steps to regulate securities lending activity. In the US, there’s a danger that Congress or the SEC [Securities and Exchange Commission] might step in with a very heavy hand without really understanding some of the ramifications of their actions. Also, Dennis, you talk about liquidity in cash collateral management pools, this is a huge issue and I don’t think it’s been resolved. The SEC’s reforms of money markets didn’t really tackle this issue either. As a result, what we see now is an opportunity for new kinds of cash management products, including things like variable Nav funds that account for greater liquidity management and transparency.
Funds Europe: How straightforward is the process of securities lending in the US?
Galper: I think it’s pretty straightforward, so long as lenders are payng attention. Before the crisis, a number of beneficial owners had heard about the great money that they could get from securities lending and thought there was very little risk attached to it. They were very happy to move forward only to be unhappily surprised later on. The process itself is very straightforward though, and there are some examples of low risk activities. If you wanted an overnight product like repo, where you’re not going to get a lot of return but you’re going to have daily liquidity, that is fairly low risk.
Wood: I would agree. When evaluating programmes, most of the scrutiny today is around what happens to the cash collateral. Securities lending and cash collateral decisions are an investment decision like any other and often times one of the larger decisions that a beneficial owner is going to make. Historically, they haven’t spent much time deciding whether cash is being invested they way they want it to be, what the risks are and how the decision affects their overall risk programme. So a key piece of scrutiny going forwards is going to be around whether they are investing appropriately and whether they bifurcate that decision, lending versus investing the cash.
Galper: From the beneficial owner’s side, the major change we’ve seen is on the oversight of cash collateral management guidelines. We see groups monitoring daily, weekly and monthly. We’ve seen guideline revisions that were talked about a year or two ago and are now being implemented. It’s always healthy having people paying more attention to what is clearly, as Freeman noted, an investment activity.
Zeppieri: At Citi we carefully work with lenders to structure a cash collateral investment programme consistent with what they direct us to do. We allow for each client to have a separate dedicated account where the client dictates the investment guidelines. It can be as conservative as they want. While some clients are interested in a SEC Rule 2a-7 type of portfolio [a type of money market fund], it depends on the individual client investment objectives.
In the aftermath of the financial crisis it became evident that many lending agents operated programs where the only cash collateral option was a pooled investment vehicle. Many of those pools purchased assets that became illiquid and in certain cases defaulted and that’s where we saw most of the problems. In some of the funds with illiquidity, redemptions were halted and lenders were unable to withdraw their monies and in certain cases were reported to have realized losses attributable to defaulted assets. As mentioned earlier, Citi’s offering enables clients to tailor a cash collateral programme exactly how they want their cash to be managed. By affording a lender the abililty to direct the investment of collateral consistent with their individual risk parameters in a uniquely designed account, a lender is in a better position to control and manage the risks of investing of collateral.
Sylvester: This has been one of the biggest shifts since the crisis. Clients are far more interested in a dedicated separate account capability from their lending agent. These platforms allow the beneficial owners to determine the parameters governing their reinvestment portfolio. It gives them a lot of transparency, oversight and involvement in the process which ultimately creates a strong partnership with their lending agent.
Funds Europe: How far did the securities lending market retract in the US? Has it come back to strength as quickly as you thought it would have?
Zeppieri: Immediately after the Lehman crisis, lenders were reluctant to come back into the market. That seems to have been well managed because the metrics would support the comment that there’s been a significant improvement from 2007. Where we continue to experience challenges as an industry is in respect of reduced trading flows. The stagnant interest rates have presented a real challenge. Also, we have borrowers that are challenged with balance sheet constraints. This has led to reduced trading flow, and that’s something that we should change over time. Also, we’ve seen the market shift from a broad array of liability generation to more of a focus on specials. There are still general collateral trades being done, but not quite to the same degree as when we are in a more compelling interest rate environment.
Wood: I would agree. The impact on volume is more on the borrower side than on the lender side, which is a bit surprising. The losses the lenders experienced on the cash collateral investment side certainly made them step back and re-evaluate the programmes. They stopped the programmes where they could and got out where they could. But then I think they realised that many of the functions designed to protect their lending programme already existed and that they needed to spend more time on the cash collateral side of things. So, the lenders are getting more comfortable and more willing to lend, but there isn’t a compelling revenue equation right now, other than in specials, and that’s the difficult part. The net revenue numbers are just not very compelling relative to the risks that still exist in this area of the market.
Zeppieri : And we don’t have a complete alignment between borrower and lender objectives at the moment. One of the lenders’ primary objectives is liquidity while the borrowers would very much like to see term activity, at least on the fixed income side, so there is a disconnect.
Galper: We feel that there is a structural change in hedge funds and in hedge fund borrowing activity, which means the market will not return to 2008 levels for many, many years to come.
We see an increase in demand for assets that use leverage, though much less leverage than before, so as Anne noted, you can now have more lending availability and more comfort with it because, in part, less loans are being made. This makes it easier for a beneficial owner that might have 2% of their assets on loan as opposed to a few years ago where they had maybe 10% or 20%.
Funds Europe: In the European marketplace the general consensus may be that although there is a demand there, market volatility has seen hedge funds adopt more of a mutual-fund business model and they are therefore not shorting. Together with lack of M&A and leverage, these are what are holding the market up.
Sylvester: I would challenge what was said about predicting hedge fund activity. There is no disputing the uncertainty around regulation, which is a big issue and could impact future market activity, but hedge funds are under pressure to produce returns. 2010 has been another challenging year for many hedge fund strategies. Eventually, these funds need to get back to what they do best, which is to capitalise on market anomalies. Over time, as more opportunities in the market materialise, hedge funds will increase their trading activity, which will help drive demand for lending.
Funds Europe: What is the percentage of the top beneficial owners who actively lend securities in the US market? In the UK/European market around 80 to 85% a top pension funds are said to actively lend.
Galper: On the public side I would say around 75% of the funds in our database are lending.
End of part 1
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